With the stock market in nearly nonstop rally mode over the past five years, investors haven't needed to look far to uncover an abundance of growth stocks. But not all growth stocks are created equal. While some could still deliver extraordinary gains, others appear considerably overvalued and might instead burden investors with hefty losses.
What exactly is a growth stock? Though it's arbitrary, I'll define a growth stock as any company forecast to grow profits by 10% or more annually over the next five years. To decide what's "cheap," I'll use the PEG ratio, which compares a company's price-to-earnings ratio to its future growth rate. Any figure around or below one could signal a cheap stock.
Here are three companies that fit the bill.
1. Smith & Wesson (NASDAQ:AOBC)
First up this week is gun manufacturer Smith & Wesson, which I'd suggest is doing a good job of finding the mark when it comes to capitalizing on growth opportunities.
As with all gun makers, the biggest headwind is typically politics. Both Smith & Wesson and Sturm, Ruger witnessed a surge in demand following the suggestion from some lawmakers that tougher gun control laws be implemented. Gun owners and supporters took these suggestions as a hint that they'd better purchase their firearms before more stringent laws are proposed or implemented, and it wound up sending demand through the roof, making last year's year-over-year comparisons downright ugly as demand returned to "normal." If tougher gun control laws are adopted it could adversely impact sales for both companies.
However, with much of those ugly comparisons now safely in the rearview mirror, I'd opine that Smith & Wesson's growth prospects are back on target.
Although Smith & Wesson's third-quarter earnings results pointed to a 10.5% decline in year-over-year revenue (as expected, considering the aforementioned law-induced demand surge), the company's net sales of $130.6 million exceeded its prior guidance as demand for hand guns and long guns is beginning to return to normalized levels. What this implies is that Smith & Wesson's product line remains innovative, and that's going to be important in its ongoing battle with Sturm, Ruger and smaller manufacturers for business.
More importantly, Smith & Wesson is focusing on the elephant in the room: the U.S. Army. The Army is looking for as many as 500,000 pistols for its officers and military police in what could wind up being a $500 million initial order per the Boston Globe. If Smith & Wesson can sway the Army to choose it over incumbent Beretta it could be a multi-year windfall for the company. You see, the federal government and its military branches really don't like changing weapons manufacturers. Beretta has held the Army's handgun contract for the last 30 years, meaning Smith & Wesson could secure a handsome new stream of annual revenue should it win this contract (which I believe it will).
At a forward P/E of 13 and a PEG ratio around one, I believe there's ample room for Smith & Wesson to head higher.
2. Alliance Fiber Optic Products (NASDAQ:AFOP)
Second up this week, I'm going to take a walk down memory lane to a small-cap technology company I once owned for many years, and suggest that cheap growth stock investors add Alliance Fiber Optic Products to their radar.
Alliance Fiber Optic Products, as its name implies, provides connectivity solutions to optical networking systems around the globe. The concern with a company like this is twofold. First, as a small-cap company it has very limited analyst coverage, meaning come earnings time its beats or misses can cause wild fluctuations in its share price. The other factor investors should consider is that we're dealing with a sector that's somewhat commoditized and prone to growth cycles. Alliance Fiber Optic needs strong U.S. and Chinese economies in order to thrive.
Despite these concerns, I'm once again keeping a close eye on this small-cap optical networking equipment supplier.
The primary reason Alliance Fiber Optic is attractive has to do with the rapid growth in data centers and robust network expansion by our nation's largest telecom companies. Businesses big and small understand that in order to be able to grow in today's economy the cloud is practically a necessity. Alliance Fiber Optic is one of numerous equipment suppliers that benefit from these data center build-outs. Networking giant Cisco Systems in 2011 projected that the market value of data centers could grow sixfold by 2020 to $241 billion, placing Alliance Fiber Optic in the driver's seat of a rapidly growing and evolving industry.
Another oft-overlooked aspect of Alliance Fiber Optic -- and I say this as a prior shareholder -- is its consistent profitability. Its growth simply flies under the radar, as does the company's $65.2 million in cash and cash equivalents with no debt as of the end of the most recent quarter. Based on its current prospects the company is valued at just 14 times next year's profit projections, and is sporting a PEG ratio of less than 0.7.
I'm not sure it has any more quick doubles left in the tank, but over the long run I could see Alliance Fiber Optic outperforming the broader market averages.
3. Taro Pharmaceutical (NYSE:TARO)
Finally, if you're looking for a cheap growth stock idea out of the health care sector I'd suggest looking overseas to Israeli-based Taro Pharmaceuticals.
Taro is a hybrid drug developer, producing over-the-counter dermatological and topical products, as well as innovative prescription drugs in the cardiovascular and neuropsychiatric fields.
As with most hybrid drug developers, this allows Taro to benefit from both worlds. On one hand, it gets to reap the high margins and incredible pricing power that comes with branded drugs. Unfortunately, branded drugs have only a finite period of patent exclusivity. This is where its OTC portfolio comes into play. While OTC products and generics have lower margins, the sheer volume of prescriptions written and product sold more than makes up for the pressure on Taro's margins.
We witnessed this balance play out most recently in the company's third-quarter earnings results. Even though Taro saw a volume decrease in all of its geographic segments, sales increased 11.3% to $237.7 million, gross margin rose 70 basis points to 81.4%, research and development expenses fell 15% to $12.8 million, and its adjusted earnings per share rose 28.7% to $3.33! This implies that Taro maintains prudent control of its spending, and that it has excellent pricing power on branded drugs.
As Taro also noted in its quarterly press release, it has an abbreviated new drug approval waitlist of 30 drugs at the moment. Because patented drugs only have a finite period of exclusivity, it means companies like Taro, which make biosimilars and generics, will always have therapies that can be targeted to generate new income streams.
Lastly, we're talking about a well-capitalized hybrid pharmaceutical company that ended its latest quarter with more than $17 per share in cash and a negligible amount in debt. This cash provides an ample backdrop to support its branded and generic studies, as well as provide support when product volume growth is less than stellar.
Sporting a PEG ratio of less than one and a forward P/E of 12, Taro Pharmaceutical could be the perfect international growth stock addition to your portfolio.
Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.
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